Saturday, March 17, 2012

Stronger than markets and economics

Whether the coming collapse is slow and orderly or takes place rapidly and haphazardly is not possible to foresee. As one wag observed, these things happen slowly until they do not. Thus, most people will not realize what is happening until it is too late.

What is clear is that a currency debasement strategy, the subtle and age-old way to default on debt obligations, has been selected by Europe and the US. By paying contracted debt back in nominal currency which has been devalued, the lender is being cheated. The monies purchases less than what was anticipated at the time of the debt contract. In essence, the government cheats all debt and fixed contract holders in an attempt to pretend to “honor” their obligations without outright default.

The description of this process is called inflation, and it can be as devastating as an outright default without the stigma associated with a legal default. In essence, the Federal Reserve has practiced this policy since its inception in 1913. From the time of its formation until today, the dollar has lost 96% of its purchasing power. “Lost” is a euphemistic term to hide the fact that the government has stolen this amount from its citizens, especially lenders and those living on fixed incomes.

There is political motivation to develop a new reserve currency by all countries other than the US. No existing currency other than the dollar can serve this role today. Regional currencies, ala the Euro, are possibilities. So too is a new one-world currency. Statists and one-worlders have pushed for this latter solution long before this crisis.

It is unlikely that a change of this sort can occur quickly because of politics. It is also ironic that such a change would put most of the world on a system akin to the failing Euro. Never mind that the Euro will fail; politicians always believes they are stronger than markets and economics. History always demonstrates the fallacy in such delusional thinking.

One thing is certain: the current situation cannot hold much longer. We are headed for sovereign defaults in numerous countries. The US, even with their dollar hegemony, cannot escape this fate.

It is impossible to reasonably forecast what will happen. Every day brings more pressures that are harder to containvia the old tried and trusted methods of “sweeping the problems under the rug.” The rug is now bulging with all the debris it contains. We edge closer to a worldwide currency collapse. There are no good options, at least from the political perspective. Here are the main options left:

Belt-tightening

Governments could slash spending and social programs to the bone. That is the only real solution to the problem, but it is considered “impractical” or “impossible.” In the case of the U.S., it would mean halving current government spending, including dramatic changes to social security and medicare. Changes of this magnitude will not happen because no politician has the courage to undertake such actions.

After almost a century of convincing citizens that government is the source of goodness and wealth, it is impossible to reveal the obvious — “we lied; there is no Santa Clause. Blood in the streets would ensue among a populace that is convinced it is entitled to live off others. Any other watered-down solution is nothing more than can-kicking, an attempt to buy time without truly addressing the underlying problems. These politically palatable half efforts might buy some more time but only at the expense of greater future pain. What is the point of buying time if it does not advance a solution?

Benign Neglect

Ignoring the obvious is exactly what caused us to reach such extreme danger. In this scenario the political class continues funding whatever deficits arise, as if there were no consequence. Eventually markets make this alternative either impossible or so expensive that expensive that governments can no longer afford the interest payments on their debt. This strategy is more of the “kick the can” approach that put us into the current predicament. It is by far the favored political choice, even in Europe where “austerity” is given lip service but will not be implemented in any meaningful fashion.

Currency Devaluation

The third option is deliberate currency destruction. In a fiat currency world it is easy to destroy the purchasing power of a currency. That is why I am so amazed at so many excellent analysts that argue that we cannot have inflation or hyperinflation in an over-leveraged society. As I understand their argument, debt destruction via defaults and bankruptcy is necessarily deflationary. That point is correct, but it assumes that government will passively stand by and allow this deflation to occur. I believe they will not.

So long as government can run its printing presses faster than debt defaults occur, there will be no deflation. That is not difficult to do and government has demonstrated a great deal of skill in this regard. Once matters begin to get dicey regarding debt defaults, I believe they would easily switch to a more aggressive tactic than the mere printing of money. Why not issue a brand new currency? Here is a simple scenario as to how this could happen.

New Currency

Tomorrow morning you awaken to a news announcement that a new currency will be issued. Some excuse(s) will accompany the announcement. These are not important, nor will they be valid, but could include reasons like counterfeit threats, national security considerations or a host of other phony reasons. The announcement states that within two weeks all existing currency will become obsolete. It must be turned in for “New Dollars” “New Dollars.” The exchange rate is one old dollar will get you two “New Dollars.” Existing bank deposits will automatically be doubled. It should be obvious that each New Dollar will only purchase half as much as each old dollar.

The kicker comes when it is mandated that all existing contracts can be met with New Dollars. So, if you owe $100,000 to someone, you can satisfy this obligation by paying him $100,000 of New Dollars (which are only worth half of the dollar on which the contract was struck). Overnight a law effectively reduces the debt burden in the country by 50% and raises the inflation rate by 100%, It does so by stealing wealth from the lenders and transferring it to borrowers. Banks would be the hardest hit, but government merely prints whatever amount of new dollars is required to make them whole. A massive new bailout with newly printed money bails out the banks.

Overnight inflation rises by 100% and then rises again with the bailout of the banks. Overnight pension problems like social security are solved, although payments buy 50% or less of what was anticipated.

Inflation is easy, but it is no solution to the problem. Yet it is more palatable in politician’s eyes than deflation which raises the costs of servicing debt. Or more palatable than truly reducing benefits to levels which can be afforded by government. Instead, the criminal class in Washington will choose to defraud its citizens rather than deal with the truth.

This action is manufactured inflation or hyperinflation. It is government cutting all its prior obligations (debt and social promises) in half by reducing the purchasing power of the currency by half (or more). It is a process which destroys retirees living on fixed pensions. It also destroys all savings and wipes out the middle class.

Workers see their wages and salaries rise, likely in line with prices. Hard assets double in value overnight. Even those who are fortunate to have their incomes increase proportionately pre-tax are made worse off as they are pushed into higher tax brackets, not because their purchasing power has increased but because their nominal incomes have. The government collects substantially more in taxes from this “bracket push,” especially from the phony capital gains that result. Everyone is made poorer except government.

Will it work? Of course not! This is what created the conditions for Hitler’s rise to power. Its results in other countries were always failures, often with great bloodshed.

Will this situation play out as I have outlined it? Probably not, but whatever occurs will likely be similar in its effects on citizens. Government is the predator and you are the prey.

I know of no asset that protects as well under such a scenario as well as gold — preferably physical gold. And, I am not sure that will even be effective in what may lie ahead. It may be the best of inadequate alternatives.